This article will be of more interest to retirees than it will to current federal employees, however, if you’re close to retirement, you will pick up some helpful information if you read it.
Most FedSmith readers have by now filed their federal income tax returns, though a few, like me, have filed extensions and have until October 16th (the 15th is on a Sunday) to file.
Many retired feds will have had a nasty surprise once they saw the bottom line on their federal income tax return because withholding can be significantly different for retirement income than it is for employment income. If you are one of those who ended up paying a lot (perhaps even facing the Estimated Tax Penalty), this article will give you some hints as to how to avoid owing a lot of taxes on Tax Day next year. If you’re about to retire, it will help you avoid a large payment of tax due in your first year of retirement.
While you’re still working you simply file a W-4 and taxes are withheld from your paycheck. You “set it and forget it”. It’s different when you retire.
Regarding your federal annuity (CSRS or FERS), you likely filled out a W-4P with your retirement papers and taxes are being withheld from your monthly payments. You probably based this withholding on the last W-4 you filed while still an employee and it most likely covers all taxes due from your CSRS or FERS annuity.
Where it gets problematic is when we get to your Social Security and TSP withholding.
It is quite likely that 85% of your Social Security will be subject to federal income tax at your rate for ordinary income, though some retirees will find that a lesser portion is considered taxable; the higher your income the higher the percentage of your Social Security benefit that is subject to federal income tax.
But Social Security will not withhold anything from your payments for taxes unless you ask them to! The key to avoiding a tax surprise is to pay the income tax on your Social Security as you go. You can:
- Ask Social Security to withhold from your monthly payments. You can do this when you apply (if you’re applying online, you do it in the “remarks” section of the form) or you can file a form W-4V after you have applied.
- Make quarterly estimated tax payments. These payments which are due on April 15, June 15, September 15 and January 15 (or a few days later depending on the day of the week the 15th falls on) require you to remember to set aside the money for the payment and remember to actually send it in. I don’t trust my memory (or my ability to keep my hands off money that I have set aside) so, when I filed for Social Security, I requested that they withhold 25% of my payment for federal income taxes.
The Thrift Savings Plan withholds taxes at different rates for different types of payments. They have a booklet available on their website that contains a detailed table describing the withholding on each different type of withdrawal.
According to TSP statistics, the most common withdrawal is one called “substantially equal monthly payments” and that that type of withdrawal (if the payments are like to continue for 10 years or more) is withheld as if you were married, filing jointly, and claiming 3 exemptions.
Really? A CPA colleague of mine calculated that you would have to be withdrawing slightly over $1,700 per month before the TSP begins withholding.
How do you keep from having a nasty tax surprise with your TSP distributions? Pretty much the same way you would with Social Security:
- Increase the amount of withholding by completing the withholding portion of your TSP withdrawal form. If you’ve already begun distributions and want to have more withheld, you can file a W-4P. During the annual open season, you could also change your withholding on form TSP-73 (the form is only available on the TSP website during the open season).
- You could choose to make quarterly estimated tax payments, as described above in the discussion of Social Security.
Most of us don’t like to pay taxes – but we have to. What we don’t have to do is pay penalties that result from our underpaying taxes due to the fact that we do not understand how taxes are withheld from retirement income. If you were stuck owing a lot, including a penalty; make changes now so that it doesn’t happen again in the future.